a forum for news, ideas and commentary on the art and science of long-term investing

Investing like James O’Shaughnessy

In any field it’s fascinating to watch what the heavy weights are up to. John Reese, founder and CEO of Validea and Validea Capital Management, (pictured) has spent the last 15 years studying history’s best investors and then building investment strategies based on that research. Among his “gurus”: Warren Buffett, Peter Lynch, Ben Graham and others. In the August 20th, 2010 issue of his newsletter, the Validea Hot List, Reese takes an in-depth look at James O’Shaughnessy, an expert in quantitative stock modeling. O’Shaughnessy’s methods have inspired a Validea strategy which Reese says has averaged more than 8% annualized returns since its inception seven years ago, a period in which the S&P 500 has returned about 1.2% per year.

Below is a reprint of part of Reese’s write-up and a list of current stocks that score highly based on his O’Shaughnessy model.

To say that James O’Shaughnessy has written the book on quantitative investing strategies might be an exaggeration — but not much of one. Over the years, O’Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor’s Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.

In addition to finding out how certain strategies had performed in terms of returns over the long term, O’Shaughnessy’s study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns — what he called his “United Cornerstone” strategy.

The United Cornerstone approach is actually a combination of two separate models that O’Shaughnessy tested, one growth-focused and one value-focused. If you’d invested $10,000 using the United Cornerstone approach on the first day of the period covered by O’Shaughnessy’s study, back in 1954 you could have had almost $7.6 million by the end of 1996 — more than $6.6 million more than you would have ended up with if you’d invested $10,000 in the S&P for the same period! That seems powerful evidence that stock prices do not — as efficient market believers suggest — move in a “random walk,” but instead, as O’Shaughnessy writes, with a “purposeful stride.”

The Two-Pronged O’Shaughnessy Attack

Let’s start with O’Shaughnessy’s value stock strategy. His Cornerstone Value approach targeted “market leaders” — large, well-known firms with sales well above those of the average company — because he found that these firms’ stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch — should hold some value stocks.

To find these firms, O’Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean.

Another key factor that was a great predictor of a stock’s future, he found, was cash flow. My O’Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average.

Even more important to O’Shaughnessy than cash flow: dividend yield. He found that high dividend yields were an excellent predictor of success for large, well-known stocks (though not for smaller stocks); large market-leaders with high dividends tended to outperform during bull markets, and didn’t fall as far as other stocks during bear markets. The Cornerstone Value model takes all of the stocks that pass the four aforementioned criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval.

The Cornerstone Growth approach, meanwhile, isn’t strictly a growth approach. That’s because one of the interesting things O’Shaughnessy found in his back-testing was that all of the successful strategies he studied — even growth approaches — included at least one value-based criterion. The value component of his Cornerstone Growth strategy was the price/sales ratio, a variable that O’Shaughnessy found — much to the surprise of Wall Street — was the single best indication of a stock’s value, and predictor of its future.

The Cornerstone Growth model allows for smaller stocks, using a market cap minimum of $150 million, and requires stocks to have price/sales ratios below 1.5. To avoid outright dogs, the strategy also looks at a company’s last five years of earnings, requiring that its earnings per share have increased each year since the first year of that period.

The final criterion of this approach is relative strength, the measure of how a stock has performed compared to all other stocks over the past year. A key part of why the growth stock model works so well, according to O’Shaughnessy, is the combination of high relative strengths and low price to sales ratios. By targeting stocks with high relative strengths, you’re looking for companies that the market is embracing. But by also making sure that a firm has a low price to sales ratio, you’re ensuring that you’re not getting in too late on these popular stocks, after they’ve become too expensive.

To apply the relative strength criterion, the Cornerstone Growth model takes all the stocks that pass the three growth criteria I mentioned (market cap, earnings persistence, price to sales ratio) and ranks them by relative strength. The top 50 stocks then get final approval.

The O’Shaughnessy-based portfolio will pick stocks using both the growth and value methods I described above. It picks whatever the best-rated stocks are at the time, regardless of growth/value distinction. Currently, the strategy is finding more buys using the growth approach. Here’s a look at the 10-stock portfolio’s holdings (growth/value distinction in parentheses):

JOSB JOS. A. BANK CLOTHIERS, INC. (Growth)

HS HEALTHSPRING, INC (Growth)

ROST ROSS STORES, INC. (Growth)

TJX THE TJX COMPANIES, INC. (Growth)

CAAS CHINA AUTOMOTIVE SYSTEMS, INC. (Growth)

LKQX LKQ CORPORATION (Growth)

SNY SANOFI-AVENTIS SA (ADR) (Value)

CHL CHINA MOBILE LTD. (ADR) (Value)

CSH CASH AMERICA INTERNATIONAL, INC. (Growth)

MWIV MWI VETERINARY SUPPLY, INC. (Growth)

Beyond The Numbers

O’Shaughnessy is a pure quant, but you should be aware that some of his most critical lessons are less about specific criteria and numbers than they are about the general mindset an investor must have. Perhaps more than anything else, O’Shaughnessy believes in picking a good strategy and sticking with it — no matter what. In What Works on Wall Street, he writes that in order to beat the market, it is crucial that you stay disciplined: “[C]onsistently, patiently, and slavishly stick with a strategy, even when it’s performing poorly relative to other methods.”

The reason involved human emotions, which cause many investors to bail on a good approach and jump onto hot stocks or strategies that are often overhyped and overpriced. “We are a bundle of inconsistencies,” he writes, “and while that may make us interesting, it plays havoc with our ability to invest our money successfully. Disciplined implementation of active strategies is the key to performance.” Wise words, whether you follow O’Shaughnessy’s approach or another proven method.

What Type of Investor Are You?

Understanding your investing profile to achieve your financial goals starts with a few simple questions. The Investor Questionnaire, by Folio Investing, will help you understand your investment time horizon, investor profile and level of risk.